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A Banking Bridge to the Future

December 11, 2009

This is an article I wrote for Risk Management Magazine back in June – seems like a lifetime ago! It’s relevant but somewhat dated. I’ve included it because many of the larger issues are still relevant and a continuing source of management angst.

Also, thanks for your comments, I’ve added a bit at the end – Things to Think About – section to help summarize the issues. 

A Banking Bridge to the Future, Robert McGarvey June 09

Although many new bridges are about to be constructed in this period of ‘stimulus’, the one bridge that is not under construction, nor even contemplated, is potentially the most critical infrastructure project of all: the risk management bridge that could connect the enormous mountains of savings and investment that are accumulating in our financial system and the productive (but under-capitalized) heart of the nation’s value creation engine.

Banker’s Dilemma

The collapse of Wall Street investment banking has unleashed a tsunami of unwelcome expectation on the conventional banking industry. At the same time that governments throughout the world are pressuring banks to be more active on the lending front, their world is falling apart: bank balance sheets are unraveling while entire arenas of bank profitability are vanishing before their eyes.  To compound the problem, bankers have suddenly awoken to the true – shocking – reality of their risk exposures. All in all, the speed of the economic collapse, coupled with bankers’ growing uncertainty around their fundamental business model has led to a kind of institutional paralysis.

How did banking, of all industries, get to such a place? Well, during the past three decades, the conservative world of banking has undergone some remarkable and quite radical changes. Since the elimination of restrictions on banking activities in the 1980’s many commercial banks have moved strongly into non-traditional (and higher risk) lines of business such as investment banking, securities brokerage, insurance, and mutual fund sales. In recent years banking profitability has become increasing dependent on a host of nontraditional banking services, electronic funds transfer fees, credit cards services and account management fees. Advances in securitization have certainly accelerated this trend, increasing banks dependence on newer non-traditional sources of profit, including loan origination fees and, until recently, fees associated with asset-based loan securitization.

All this banking ‘service’ growth has diverted public attention from a disturbing trend: the precipitous decline in a pillar of banking industry stability, commercial and industrial (C&I) lending. According to Cobas Mote, and Wilcox:  Probably the most important change in banking (in the last few decades) has been the “…reduction in banks’ role as a lender to non-financial corporation’s… the ratio of commercial paper outstanding to bank commercial and industrial loans, which was just over 10 percent in 1960, rose to about 30 percent in 1975 and to more than 100 percent by the early 1990s.”. This trend has accelerated in the last two decades. Between 1986 and 2003 Commercial and Industrial loans declined from 31.53% to just 18.9%  of overall industry loan portfolio, as large business borrowers began to bypass regulated banks for Wall Street financial institutions substituting commercial paper or high-yield debt for bank loans secured against collateral grade assets. 

The Asset Revolution

This transformation in the banking business model has been driven by many factors including advances in technology, the development of sophisticated credit-scoring models, new financial processes, the Internet and, of course, by cold-blooded financial pressures, the need to meet profit and growth targets in an increasingly competitive market. However, a significant, if underreported reason for all this change in banking strategy, is the persistent decline in the quantity of traditional bankable assets in modern corporations. According to the World Bank there has been a revolution in the underlying engine of growth in western economies; a precipitous decline in tangible industrial-type assets as a percentage of total market capitalization. Today, in most ‘post industrial’ economies market services and intangible assets dominate, contributing over three-quarters of GDP. 

 

What does all this mean in the conservative world of banking? Today as banks retreat from high yield financial derivatives and begin to search for solid collateral they are facing, head on, the transformation of the underlying asset foundation in western economies. Instead of the bankable assets of old, real property, plant or inventory, corporations in the modern economy are underpinned by host of non-traditional ‘assets’. These new assets include many of the ‘harder’ (potentially bankable) forms such as patented new technologies, copyrighted software, but they also include many new contractual based assets, not least those ‘sophisticated’ financial derivatives we’ve all read about, and a variety of unfamiliar relationship based assets such as ‘brands’, trademarks, social networks and related assets that are becoming more and more important in our economy.

The scale of this economic revolution and the immaturity of the actual assets (from the banking perspective) make it extremely difficult for banks to move quickly, to adequately fulfill the rising expectations of business, governments, regulators and an increasingly impatient public.

The Lesson’s of History

It’s been a long time since bankers have faced such a challenge. The last time western banking went through as profound an asset transformation as we are presently experiencing was at the dawn of the industrial revolution two centuries ago. The dilemma then facing bankers was described well by John Jay Knox, in his ‘History of Banking in the United States’ (1903). “Money banks… issued notes on the basis of obligation of merchants and manufacturers, in contrast to land banks which issued their notes on the basis of land and personal estates. The latter type of banking was considered (prior to the War of 1812) preferable to banking on mercantile credit because land banks were supposed to stand on solid ground and not to depend on the success of their borrowers as did the money banks.” The historic importance of American bankers of the time, according to Knox, lay in their recognition of the changes brought about by the industrial revolution and an appreciation of the changing focus of (intrinsic) value in an industrial economy. “Such were the ideas of the men who stood at the cradle of (modern) American banking, and their choice lay between banking on mercantile credit or banking on real and personal estates. It was in choosing the first possibility that they made history.”

History has raised the bar again. The value creation engine in our economy is migrating, moving rapidly into new asset forms that need institutional support of all kinds, including banking. If there is to be a significant role for banks in the post industrial economy some things must change and change quickly. To begin with banking risk management standards and risk tolerances will certainly need to be developed internally, predicated on first principles, and not simply outsourced to credit rating agencies. Secondly risk must be identified and managed, not veiled behind statistical models or blindly hedged with credit default swaps etc, and – most importantly – thoroughness, diligence and openness need to be guiding principles for managers.

It is no longer possible to support the fiction that the new engines of growth in our economy are simply Good Will, ‘services’ that can escape rigorous analysis. Fortunately the risk management profession has just the right mind-set and tool kit to deal with all these problems. One of risk management’s most attractive attributes is its formal disciplined treatment of assets. Risk management processes seek quality verification of assets at discrete stages: (1) identification of the assets, what exactly is the asset, how does it deliver value to the company? (2) the current state of the assets, what does the company ‘own’ and what is its condition? (3) performance criteria, what level of performance or service are required, how is performance measured, how do these asset fail? (4) life of the asset determination and (5) what is the strategic ‘best use’ of the asset, are there alternative uses of this asset?

Adapting to New Assets

Nontraditional assets need to be identified and given the same rigorous treatment as traditional assets. Where this is presently being done quantitative valuations of intangibles (software, patents, trademarks etc.) are beginning to show up on financial statements, strengthening corporate balance sheets. Software, despite its obvious attraction as an asset has only been treated as such since 1999 under GAAP. But intellectual property based assets are not the only, nor the most productive new assets: brands, customer equity, employee know-how (human capital) and other key stakeholders contribute significant value to corporations, and are beginning to appear on the radar screen of major accounting bodies as ‘potential’ capital assets of the future. 

 The question is will we, standing at the cradle of another new era, have the vision, the creative imagination and the strength of character of our forbearers? Are we prepared to engage once more in an historic act of social invention, to do the hard work necessary to unleash an era of new prosperity?  Or will we continue to wring our hands, and hope that the Humpty Dumpty of 20th century banking can be put back together again? History is calling, are we prepared to answer the bell?

Things to Think About:

  1. If it’s not an asset for you, don’t expect your accountant to capitalize it! (or your banker to bank it) Management should be asking themselves the question “what are the real value drivers in our organization“,  presuming you can identify the newer nontraditional sources of value, ask yourself if you’re doing everything you can to treat them like a formal asset.
  2. Thanks to the rest of us pulling out all the stops, banks are recovering, but they still have difficulty identifying and managing risk in an evolving economy, and show no willingness to begin capitalizing the new engines of growth in our economy.
  3. Expect more uncertainty and volatility to emerge from a shaky financial system. Its belts and braces time for the CFO’s: have a plan, have a back up plan and work diligently to ensure that you’re prepared for any eventuality.  

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